Monday, June 8, 2009

The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where the financing of capital formation relied on existing accumulations of savings. As we have seen, not only were there insufficient savings to account for financing the incredible amount of new capital formed in the United States between 1830 to 1930, Keynes' belief that investment can only take place after cutting consumption and saving neglects one colossal fact on which Keynes also insisted: savings equals investment.

Had Keynes been consistent, he would have realized that he had said some things that, when they are put together, simply don't make sense: 1) savings consists of unconsumed income. 2) Savings equals investment, and 3) financing for capital formation can only occur by cutting consumption in order to save, or by liquidating existing investments.

Logically, then, there can never be any more of anything than already exists. If, as Keynes claimed, savings equals investment, then saving by one individual means investment by another — as Keynes admitted in his General Theory (II.6.ii). Thus, the only way to finance new investment is to liquidate existing investment!

This is a "chicken or the egg" argument. New capital investment can only be financed out of existing accumulations of savings . . . but all savings are already invested. If we wish to finance new investment, we must liquidate old investment . . . which means that the new investment is equal to the old investment, and we haven't really gained anything!

The problem (one of the problems, anyway) is that Keynes didn't understand the science of finance. He was absolutely correct that savings equals investment. No sensible person leaves accumulations of savings in the form of cash, except to supply working capital, which is itself an investment. He was absolutely wrong, however, that savings are used directly to finance new capital formation.

Savings are already in the form of investment. The accumulations of savers, assuming that they do not themselves invest directly, are deposited in a bank. The bank immediately turns around and makes new loans based on the savings, limited by whatever the reserve requirement happens to be. It would not make good business sense for a bank not to make loans when it could be making money.

In actuality, of course, a bank does not lend out the savings of depositors. Savings are immediately invested in the bank's reserves. In the United States, this means government bonds. Every dollar not invested in government bonds means one dollar on which the bank is losing money, even if the interest rate on government bonds is very low. Government bonds may make very low interest payments, but vault cash pays no interest at all. All commercial banks invest as much of their reserves in government bonds as possible, and keep as little in the form of cash as they can.

Nor do banks lend out their reserves. They are, in fact, forbidden to do so. They must keep on hand sufficient cash to meet their daily transactions demand, or have enough in government bonds that they can sell at a moment's notice to meet their daily transactions demand in order to prevent a "run" on the bank.

If commercial bank reserves are not lent out to customers, then, where does the money come from to finance new capital investment?